I’ve been receiving a handful of comments asking about the QYLD ETF, so I figured it
was about time I covered it and took a closer look at the strategy.
QYLD is the Nasdaq 100 Covered Call ETF, and with a dividend yield of approximately 12%
paid monthly, it attracts a ton of dividend and income investors.
Given that it’s a yield-focused investment, I tend to read the ticker as “q-yield”,
so that’s what I’ll be calling it throughout this video.
But in this video, I want to investigate the QYLD strategy to understand how it can offer
such a sizable yield every month.
To do this, we’ll be diving into the QYLD portfolio and what its covered call strategy
looks like.
Covered calls are a common options trading strategy, and understanding that strategy
is key to understanding this ETF.
After breaking down the strategy, we’ll take a closer look at the potential returns
of QYLD, and when it makes sense to have this fund in your portfolio.
We’ll also take a look at the tax ramifications of this ETF, which is always important to
consider when dividends are involved.
Last, if you like the sound of the Nasdaq 100 covered call strategy, we’ll consider
a few alternatives that give investors more control over their returns.
So let’s take a look.
As the name suggests, the QYLD ETF invests in the Nasdaq 100 index, then uses a covered
call strategy to generate income off of those holdings, generating dividends for investors.
We’ll break down both of these components.
The Nasdaq 100 index is a market-cap weighted index of the 100 largest stocks that trade
on the Nasdaq, excluding REITs or financial stocks.
The Nasdaq 100 claims to be an innovation-focused growth index, which as I discussed in my video
comparing it to the Ark ETFs, isn’t completely accurate.
Based on the Nasdaq’s history as a technology-driven exchange, it has naturally attracted more
tech companies than something like the New York Stock Exchange.
This is why the Nasdaq 100 has outperformed the S&P500 in recent years, because it is
heavier into these tech-focused companies that could be loosely considered innovators.
I think they’re trying to use innovation as a buzzword to compete with Ark Invest funds,
but that’s just my two cents on the subject.
Anyway, there are a few ways to invest into the Nasdaq 100 index.
Most common is QQQ, an Invesco ETF that tracks the Nasdaq 100 by investing into all 100 of
its stocks as they are represented in the index.
Similarly, QYLD purchases each individual stock as represented in the Nasdaq 100 index.
So this means it will be nearly identical to the QQQ portfolio and the Nasdaq 100 index.
So as we would expect, the QYLD portfolio matches the Nasdaq 100 index almost perfectly.
And this means that as an investor into QYLD, you get “long” exposure to the Nasdaq
100 index, just like you would by investing into QQQ or a similar ETF.
However, as the Nasdaq 100 is largely made up of growth companies that pay little or
no dividends, this may not be ideal for an income or dividend-focused investor.
And that’s where the covered call strategy comes in.
Covered calls are an options trading strategy that can be used to generate additional income
from stocks, whether or not they pay a dividend.
To use covered calls, you have to own the underlying stocks.
So this is something the QYLD ETF is able to do on its portfolio because it owns all
of the stocks in the Nasdaq 100 index.
As an individual, you have to own 100 shares of a stock or ETF to perform the covered call
strategy.
Then, you can sell or “write” a covered call, which means you create a contract that
gives someone else the right to buy your 100 shares at a certain price.
Someone pays you for this contract, which helps you earn extra cash on the stock.
The catch is, if the price of the stock moves up, the other person can execute that contract
and force you to sell your shares to them at the agreed upon price.
I’ll give you a quick example with Apple stock.
So let’s say I owned 100 shares of Apple, and I want to make more income from these
shares than its measly dividend.
Since I own 100 shares, I can sell a covered call.
You can see on this option chain that Apple is trading around $134.
I can sell a covered call with a strike price of $140 and earn $4.38 per share, otherwise
known as the premium.
Since each covered call contract is for 100 shares, this would be an instant $438 for
creating the contract.
Once sold, the buyer has until the expiration date, in this case June 18th, to execute our
contract, and can only do so if the price of Apple stock is at least $140.
If they choose to execute the contract, I would be forced to sell my 100 shares to them
for exactly $140.
However, if the stock doesn’t reach that price by the expiration date, I get to keep
my shares and all of the money I collected in premium.
So as you can see, if you don’t expect the stock price to increase beyond a certain price,
a covered call lets you earn some nice income on your shares.
However, it also limits your potential returns, because if a stock shoots up, you’re forced
to sell your shares at the set strike price, no matter what price the stock ends up reaching.
But in a nutshell, this is the strategy that QYLD uses on its holdings to generate high
dividends for investors.
The only difference is, instead of selling covered calls on individual stocks in its
portfolio, it sells a covered call on the entire Nasdaq 100 index, essentially tying
up its entire portfolio in a single options strategy.
Let’s take a closer look here.
The QYLD ETF writes their covered call contracts on a monthly basis, with each contract expiring
the following month.
When they do this, they select the closest available strike price above the current price
of the Nasdaq 100 Index.
This is known as an at-the-money option, because the price needs to move very little for the
buyer to execute the contract.
This is different from the Apple example I showed you earlier, because the $140 strike
price was farther away from the current stock price of $134.
So in the case of the QYLD portfolio, they’re almost guaranteeing that they won’t earn
a large positive return on their portfolio, because the contracts will likely be executed
if the index above that strike price.
However, the interesting thing about these covered calls on the Nasdaq 100 index is that
they can’t be executed early, unlike regular call options which can be executed at any
point before the expiration date.
So the contract only gets executed if it expires with the Nasdaq 100 index at or above the
strike price.
And this means QYLD covered call strategy has some very specific implications for investors.
First of all, you’re not expecting the ETF to produce returns via price growth.
The price of the ETF will fluctuate a little bit based on the performance of the individual
stocks in the Nasdaq 100 index, but only to a certain point.
You’re expecting to receive most or all of your returns from the premiums collected
from the covered call contracts.
And this is why the price of the ETF has been more or less the same since inception, bouncing
between $20 and $25.
It caps its own growth potential in favor of collecting cash premiums and distributing
them to investors every month.
In comparison, you can see that the Nasdaq 100 index as measured by the QQQ ETF has produced
huge price appreciation over the last several years, while only offering about a half percent
dividend yield.
This particular chart makes QYLD look pretty bad - but when you consider the total returns,
which includes dividends, it’s historically produced around 9% returns a year before taxes.
Another important thing to understand about the QYLD ETF is the impact of market volatility.
First, because the covered call contracts cannot be executed until the end of the month,
market volatility doesn’t really matter until the last day of the month.
The NAV may fluctuate throughout the month, but the main concern for investors should
be whether the price of the Nasdaq 100 index falls above or below the strike price of the
contract written at the beginning of the month.
Volatility does play a role in the value of options contracts, because premiums will be
higher in a volatile market.
And that’s something we’ll consider more in a minute, because QYLD will produce higher
dividends in higher volatility, which is exactly we’ve seen recently.
But volatility aside, there are 3 potential outcomes for QYLD in a given month, which
will tell us which kind of markets we might want to hold this ETF in.
First is that the market goes down, and the month ends with the Nasdaq 100 index priced
below the strike price of the contract.
In this case, QYLD gets to keep their options premium and their stocks.
While the NAV of the fund would drop in this case, these losses would be offset by the
dividends that investors receive.
So in a bear market, QYLD can be a hedge against downward price action to limit your losses
and continue receiving dividends.
Second is that the market stays flat, with the index priced at or near the strike price
of the contract at the end of the month.
In this case, QYLD gets their options premium and the contract would likely not be executed,
so the holdings of the fund will remain the same.
This is the optimal outcome for investors, because the NAV remains the same but you still
get to collect the dividends.
The last outcome is if the market goes up.
In this case, QYLD still gets that option premium, but they’ll likely have to liquidate
their holdings to satisfy the contract when it gets executed.
This will have a small increase in fund NAV, but as we mentioned, it will be limited because
the holdings have to be sold at the strike price.
So if the Nasdaq index moves far above the strike price, investors are missing out on
any additional returns.
Considering these three outcomes, we can speculate as to when the best times to hold the QYLD
ETF would be.
As we said, it can be a good hedge in bear markets when downward price movements can
be expected.
In these cases, you can still earn some returns through dividends that can cancel out or mitigate
a loss in portfolio value.
We can see that QYLD has performed better than the Nasdaq 100 in these environments.
The best time to hold this kind of investment seems to be a flat market or a highly volatile
market.
In a flat market, the Nasdaq 100 index would not be producing returns, making QYLD a great
way to earn returns through dividends when the underlying assets aren’t moving.
Similarly, since options premiums increase with market volatility, this strategy would
be more profitable in a volatile market.
But, if the volatility skews towards the upside, you may want to reconsider.
This is because in a bull market, you’re limiting your potential returns with the covered
call strategy.
You’ll still receive dividends, but your total returns would be far greater if you
just held the QQQ ETF or a similar investment.
One last key thing to consider about QYLD is the tax implications as a dividend-focused
investment, because the cost of taxes can quickly eat into the returns of this ETF.
Ordinarily, gains from covered call options in this strategy would be taxed at 60% long-term
capital gains tax rate and 40% short-term capital gains tax rate.
Depending on your particular tax bracket, you may choose to hold this in a tax-advantaged
retirement account to reduce the impact of those taxes on your returns.
However, QYLD has been doing something pretty interesting with their recent distributions.
Throughout 2020 and so far into 2021, their distributions have been 100% return of capital.
A return of capital means they’re returning a portion of your initial investment back
to you, which is not immediately taxable.
When you receive a return of capital, you don’t pay any taxes on it, but it reduces
your cost basis in your investment.
So eventually, if you sell your QYLD shares after receiving one of these distributions,
you’ll pay capital gains taxes on an amount equal to the difference in the current share
price, and your initial purchase price minus any dividends you’ve received.
This is considered tax-deferred, because you don’t have to pay any taxes until you sell
your shares.
You just have to be careful here, because the tax hit can be pretty heavy if you’ve
held for a long time and you’re not expecting it.
But this is a clever strategy that QYLD uses to give investors more control on when they
realize their tax obligation.
They’re able to use any capital losses they receive throughout the year to offset the
gains from options premiums.
Then, they choose to give you “return of capital” instead of the money they’ve
earned through premiums.
So currently, you could be holding QYLD in a standard investment account with no immediate
tax obligation, which is great for the short term.
You just have to be aware that you will eventually owe taxes on these dividends when you decide
to sell your shares.
And that’s just about everything you need to consider about the QYLD ETF.
However, I wanted to quickly point out two alternative strategies you may also want to
look into.
First is performing the covered call strategy on your own with the QQQ ETF.
To do this, you’ll need to own 100 shares of QQQ, which is about a $34,000 investment.
But if you can pull this off, you’ll have much greater control by selecting the covered
call contracts you create.
Then you can choose strike prices that give you more room for upside growth or you can
choose different time frames to customize the strategy.
Additionally, you’ll only be paying the .2% expense ratio of QQQ, instead of the .6%
expense ratio of QYLD.
The second alternative is the new QYLG ETF.
This is the perfect blend of QQQ and QYLD.
In contrast to QYLD, which writes covered calls on 100% of the portfolio, QYLG only
writes covered calls on 50% of the portfolio, and still has all of the same stocks as the
Nasdaq 100 index or QQQ.
So with this strategy, you’re getting more upside potential than QYLD, but also getting
a larger dividend than with QQQ.
Since the high yield and covered call strategy of QYLD is a superior choice to QQQ in flat
or bear markets, QYLG, which gives its portfolio more potential upside, might fit well into
a portfolio during a volatile market or a flat market that has some potential for gradual
upside price action.
Long-term, we’d probably expect to see the yield from QYLG fall somewhere between QQQ
and QYLD, likely in the range of 5 to 6%.
But that’s all I’ve got for you guys on QYLD and its covered call strategy.
Leave me a comment and let me know how you’re using this fund in your portfolio, if at all.
As always I appreciate your support and I’ll see you in the next video.